Lessons from Canada

On April 14, in the course of a debate in the House of Representatives about the proposed Republican budget, Kevin Brady of Texas rose to speak about the nation's fiscal problems. Brady — the senior House Republican on the Joint Economic Committee — sought to make the case that, while our problems are immense, solutions are surely possible. To illustrate his points, Brady brought along a set of large charts, one of which seemed out of place in a debate over American fiscal policy. It was labeled "Canada."

The chart traced key Canadian economic statistics from 1989 onward and showed that, as Canada dramatically reduced government spending, its economy grew rapidly. Though Canada's economy grew by less than 1% between 1989 and 1993, the subsequent 13 years brought average annual growth of 3.4%. And the Canadians withstood the financial crisis of 2008 far better than we did.

How did Canada pull off this turnaround? Ottawa's strategy relied on spending cuts that were "large, credible, and difficult to reverse," Brady said. The Canadians had shrunk their government work force, the congressman noted, and "they eliminated duplicative programs...they reduced subsidies to corporations...they tackled entitlement reforms." Even when entitlement reforms were "were phased in...over time, [they] sent the right signals to the marketplace," Brady argued. Moreover, he explained,

Businesses, no longer facing higher taxes because of all that spending, felt comfortable beginning to reinvest back into their workforce, back into their country — in the economy....It's clear, time and time and time again, like businesses, countries that get hold of their debt [and] do it the right way...put themselves on a financially sound path [to] grow. And America's economy can grow as well.

Delivered in the evening before a largely vacant House chamber, Brady's speech drew scant attention, as Canada itself does in the United States. Unless they are tourists or hockey fans, Americans generally ignore our neighbor to the north. When Canada held a national election in May, the American media took little note of it. Though he governs our close ally next door and won re-election with a strong parliamentary majority, Canadian prime minister Stephen Harper is probably less known to Americans than President Bashar al-Assad of Syria. Few Americans have any idea that the United States and Canada have the largest trading relationship of any two nations on earth, or that Canada supplied more oil to the United States in 2010 than Saudi Arabia and Mexico (our next two largest sources) combined.

Even among Washington policy wonks, very few realize that, some 15 years ago, Canada successfully dealt with a fiscal and economic emergency almost identical to America's current crisis. The Canadian experience has prompted only a few op-eds, written mostly by Canadians, and some obscure academic studies. The defining analysis is "Canada's Budget Triumph," a 2010 study produced by (Canadian-born) economist David Henderson for the Mercatus Center at George Mason University. Canada, Henderson wrote, "achieved fiscal discipline, turned a budget deficit into a surplus, and in the process became one of the healthiest economies" in the world.

Canada's success is highly relevant to the challenges America now faces. "We're not Canada," Brady conceded in his House speech. But we're close. And there is much that America — and especially our national political and opinion leaders — can learn from our neighbor's stunning fiscal turnaround.

THE TIPPING POINT

Although Americans do not pay much attention to Canada, Canadians pay a lot of attention to America — and they are especially sensitive to how we view our northern neighbor. This is why two stories that appeared in the Wall Street Journal on consecutive days in January 1995 struck Canada's political class like a thunderbolt.

The first, by reporters Michael Sesit and Suzanne McGee, said that economists in both the U.S. and Canada believed Canadians had "lived too high on the hog for too long," and that "worries about Canada's fiscal and monetary policies [had] only increased" since the election of a Liberal government 14 months earlier. The article referred to the Canadian dollar as the "northern peso."

The second article, an editorial, noted that Canada had lost its triple-A credit rating, possessed "the second-highest ratio of debt to GDP of any industrialized economy," and funded "dozens of budgetary white elephants long overdue for a diet." Although there was a hint of good news — "Finance Minister Paul Martin has been making noises about a radical pruning of government expenditures" — the Journal's editors were nonetheless dubious, concluding that Canada was becoming "an honorary member of the Third World."

In his memoirs, Jean Chrétien — Canada's Liberal prime minister at the time — noted that these two slaps in the face were a great help in getting his cabinet to recognize that it was time for serious action. Of course, the Journal's revelations hardly came as news to Canada's leaders: When the Liberal Party won control of parliament in the 1993 election, the Canadian economy was a basket case. Deficits had tripled as a percentage of gross domestic product over the previous 20 years. Debt approached 70% of GDP. Payments on the debt took approximately 35 cents of every tax dollar (the government was spending more than 6% of GDP each year just to pay the interest on the debt). The government's overall share of the economy had jumped from 28% in 1960 to 53% in 1992. Federal spending accounted for 23% of GDP, up from 17% in the '60s.

Worse yet, the interest rate the Canadian government had to pay on its debt (around 8%) was significantly higher than the rate at which the economy was growing (which, in a very good year, would have been around 4.5%). Paul Martin, a former shipping executive who became finance minister in Chrétien's government, said Canada was approaching the "tipping point" at which spiraling debt and interest payments could simply no longer be contained.

Canada was courting disaster. And the reasons would be familiar to anyone who has considered America's current fiscal situation: out-of-control discretionary spending combined with an unsustainable entitlement system. Just as in America, the left and the right in Canada were both to blame for the nation's ills. The Liberal Party (under Pierre Trudeau) had governed Canada from 1968 until 1984, and had run deficits in all but one of those years. The year Trudeau left office, Canada ran an astonishingly massive deficit of 8.3% of GDP.

But the conservatives did not do much better. Governing from 1984 until 1993, Progressive Conservative Party leader Brian Mulroney trimmed spending some. But he failed to enact structural reforms, and kept federal spending at an average of 22.6% of GDP. As a result, and especially because interest rates on the debt exceeded growth throughout that time, the nation's debt-to-GDP ratio rose from 47% to 67% under Mulroney.

Something had to change. But the new Liberal government's first attempt was a flop, which seemed only to confirm the worries of investors. The budget did reform the nation's unemployment benefits (a poorly designed system filled with perverse incentives against work), which had become an enormous expense; it also cut defense outlays, subsidies for business, and government operating expenditures. Martin called it the "toughest budget ever." But it was not tough enough. Financial markets were unimpressed. The media frowned. Voters were disappointed. And the government found itself embarrassed, having promised serious action.

That negative response — including the two slaps in the face from the Wall Street Journal — made it possible for Chrétien to persuade his fellow Liberals that more drastic steps were necessary. It was the impetus for Canada's extraordinary turnaround.

REAL REFORM

The government's 1995 budget was the game-changer. Crude across-the-board cuts were ruled out, and every program was instead evaluated on the basis of six questions: Does it serve the public interest? Is it necessary? Could it be turned over to the provinces? Could it be handed over "in whole or in part" to the private sector or volunteers? Could its efficiency be improved? And if a complex program proved too costly, which parts could be eliminated? Martin's announcement of the new approach was dramatic, and rightly so: "This is by far the largest set of actions in any Canadian budget since demobilization after the Second World War," he said. "Relative to the size of our economy, program spending will be lower in 1996-97 than at any time since 1951." (Program spending includes all government spending except debt service.)

Perhaps the most striking aspect of the budget was its heavy reliance on spending cuts. Given Canada's bevy of high taxes — national and provincial, personal and corporate, income and sales — and given the economy's fragile state, a large tax increase was out of the question. "Canadians have told us that they want the deficit brought down by reducing government spending, not by raising taxes, and we agree," Martin told the House of Commons. "The era of tax and spend government is gone. Over the next three years, for every $1 raised in new revenues, we are cutting $5 in government expenditures," he pledged.

He kept his promise, and then some. Over three years, the cumulative savings amounted to $29 billion (Canadian), all but $3.7 billion taken from expenditures. In the end, the ratio of spending cuts to tax increases was nearly seven-to-one. This represented, by almost any yardstick, a historic reduction in government spending. The budget also reflected a shift in the size and scope of the federal government. Spending plummeted and the cost of debt service fell dramatically. Unemployment insurance was reduced. Federal transfers to the provinces were cut. Federal employment was trimmed by 45,000 jobs, or 14%. Government-run entities, like Canada's national railway and air-traffic-control system, were privatized. When a department head asked for increased funding, Chrétien is reputed to have snapped, "Maybe I haven't made myself clear. The next minister to ask for more money will not be a minister." Meanwhile, the provinces and the private sector gained power.

And leaders in the provinces (from both the left and right wings of Canadian politics) took similar measures. The far-left premier of Saskatchewan, Roy Romanow, had replaced a Progressive Conservative premier under whom the province's deficits had soared. Debt service alone consumed 12.4% of the budget when Romanow took over in 1991. Through a combination of spending cuts and tax increases, an $845 million deficit was turned into a $128 million surplus in three years. More remarkable than the savings was the fact that a leftist government, ideologically disposed to increase spending, led the fight to reduce the deficit. "[W]e must start to live within our means because it is the only way to rebuild Saskatchewan," Romanow's finance minister, Edwin Tchorzewski, said.

Conservative provincial leaders did much the same. Alberta's premier, Progressive Conservative Ralph Klein, labeled his legislation the Deficit Elimination Act. "We've chosen to get rid of deficits once and for all, not slowly, not a little bit at a time, but decisively and completely," Jim Dinning, the province's treasurer, said. Alberta subsequently had budget surpluses for 14 years and by 2004 had wiped out its debt entirely. In Ontario, Progressive Conservative premier Mike Harris managed to dispose of the deficit and substantially cut the rates of individual taxes at the same time.

Indeed, for a while, the policies pursued by liberals and conservatives in Canada were hard to distinguish. At the federal level, Chrétien's government imposed budget discipline in ways not normally associated with the left. Martin enforced a no-deficit rule, which he said (correctly) was a "sharp break with tradition." The government's spending cuts were not merely reductions in the rate of growth of programs and departments but reductions in real spending, year after year. They adopted conservative assumptions about economic growth and interest payments on government bonds. Yet their forecasts, as economist David Henderson noted, "were closer to the actual numbers than the private-sector forecasts were." In case those forecasts proved too rosy, they even set aside a sizable contingency fund. They were not taking any chances.

But while Martin, Chrétien, and their party may seem to have acted like libertarians, they were strong believers in government and made a liberal case for reform. Martin told liberals that controlling the deficit and debt was necessary "if we want to preserve our social programs." Tradeoffs were unavoidable. He acknowledged that the cuts and reforms required to stabilize Canada's finances were painful for beneficiaries of social programs. "There was hardship," Martin later said. "You don't want to do what we did in 1995 every decade. The costs are too great. Governments shouldn't let this situation arise." But at that time, it was simply unavoidable.

Without a doubt, however, the means to the liberal ends that Martin (and, even more clearly, Chrétien) had in mind were conservative means. Even Canadian conservatives thought so. Brian Lee Crowley, Jason Clemens, and Niels Veldhuis — three prominent conservatives, and the authors of the recent book The Canadian Century — argue that Martin had adopted the free-market principles of Sir Wilfrid Laurier, a conservative icon who was prime minister of Canada a century ago. Laurier believed in limited government, individual liberty, decentralized federalism, fiscal discipline, minimal borrowing, and low taxes. As a general matter, Martin and Laurier were not far apart. The book cites a quote from Martin's 1995 budget speech to buttress the point:

The debt and deficit are not inventions of ideology. They are facts of arithmetic. The quicksand of compound interest is real. The last thing Canadians need is another lecture on the dangers of the deficit. The only thing Canadians want is clear action.

They got that clear action from Martin.

Martin's background as a successful CEO of a large company had a great deal to do with his approach. First elected to parliament in 1988, he brought something new to the finance minister's job: business acumen. Parts of the 1995 budget document issued by his Department of Finance, A New Framework for Economic Policy, read as if they had been written by a conservative businessman, not a liberal politician. This was particularly true of its discussion of unemployment insurance. "The rules of the program have encouraged chronic, repeat use," the policy document said.

For example, almost 40 percent of people receiving UI in 1993 had claimed benefits at least three times during the past five years and the number of frequent repeaters has been rising. The average duration of spells on UI has also increased steadily. Moreover, the attractiveness of the program has induced people to enter the labor force in order to qualify. Studies estimate these factors have combined to raise the unemployment rate in Canada by 1 to 2 percentage points.

Chrétien and Martin waited until 1997 to take one of their boldest steps, transforming the Canada Pension Plan (Canada's version of Social Security) into a solvent, pre-paid retirement system. The rate of the payroll tax that funded the system was gradually raised from 6% to 9.9%, shared between employers and employees. (By comparison, our Social Security tax rate is 12.4%, split evenly by employers and employees, not counting a temporary reduction of 2% on the employee side in 2011.) And unlike in Social Security, revenues collected for the CPP are not diverted to pay for other government programs. Rather, they are invested in government bonds and diversified private assets.

The results have been nothing short of extraordinary. Between 1995 and 1998, a deficit of $36.6 billion morphed into a $3 billion surplus. This was not just a function of the hot global economy of the late 1990s: Canada continued to achieve budget surpluses for the subsequent 11 years, long after America's tech bubble burst and U.S. government finances took a nosedive. Canada's debt-to-GDP ratio was cut by more than half during the period of Liberal control. Shrinking federal payments to provincial governments and turning them into block grants yielded enormous savings and bolstered the financial independence of the provinces (which now far exceeds that of American states). Those provinces, especially Alberta, have since become hotbeds of policy innovation: School choice in Alberta is more extensive than anywhere in the U.S., and even includes modest payments to parents who home school their children.

Indeed, comparisons to the United States are embarrassing — for the United States, not Canada. Economic growth in Canada was 3.3% in 2010, compared to 2.9% in the U.S. Canada's deficit during its fiscal year 2011 (April 1, 2010, to March 31, 2011) was 2.4% of GDP; during America's FY 2011 (October 1, 2010, to September 30, 2011), our deficit is projected to be 9.8%. Government debt is expected to be 34% of GDP in Canada and 58.9% in the United States. Unemployment in 2010 averaged 8.0% in Canada and 9.6% in the U.S. Rankings by the World Economic Forum give Canada the edge in category after category. Canada's credit rating, for example, ranks fourth in the world. America's ranks 11th.

The pride and optimism generated by Canada's resurgence and role reversal — strong Canada, weak America — have been captured in Crowley, Clemens, and Veldhuis's book, published last year. Subtitled "Moving Out of America's Shadow," the book — which has been published only in Canada — is disdainful of the United States. In the foreword, Allan Gotlieb, the former Canadian ambassador to the U.S., writes that America's decline is "leaving the field open for Canada to shine." He adds: "If we want to see what would have become of Canada had we not lived through the difficult changes...we need look no further than Washington, DC, where unreformed entitlements and undisciplined borrowing are hobbling America's power to be a world leader and to outshine Canada on the economic front."

THE ENERGY WARS

One further element of Canada's economic success story has great relevance to America's circumstances. Along with the government's commitment to fiscal reform, Canada's resurgence also owes a great deal to the government's willingness to encourage and pursue domestic oil exploration — especially in Canada's so-called "oil sands" region — in the face of intense pressure from environmentalists.

The sands are a unique geological formation created when oil was pushed upwards eons ago. They span an immense area, roughly the size of Florida, in northeastern Alberta. About 20% of the oil — actually oil-saturated sand — is close enough to the surface to be strip-mined by giant shovels and carried off by trucks three stories high. The other 80% — the underground oil — can be recovered and separated from the sand with the help of a revolutionary process known as steam-assisted gravity drainage.

Environmentalists contend that extracting and producing "dirty oil" from the sands generates three times the greenhouse-gas output of conventional oil exploration. But this is true across only about one-fifth of the oil's life cycle. Measured from extraction to combustion as gasoline — on what is known as a well-to-wheels basis — emissions from this process are only 5% to 15% greater, according to Cambridge Energy Research Associates. That puts oil from the sands "within the general range of crude oils," a CERA study noted.

Opposition from environmentalist groups has shaped the media's and the public's perceptions of Canadian oil exploration. The willingness of the Canadian government to persist despite that pressure has led environmentalists to try to influence the U.S. government instead. American environmental-activist groups, more militant than their Canadian counterparts, have recently stepped up their campaign to keep Canadian oil from reaching the vast U.S. market. They demonstrated against Canadian prime minister Stephen Harper when he came to the White House in February, but the real target of their pressure was President Obama. They want his administration to halt petroleum imports from the oil sands on environmental grounds, and to cancel a project to build a pipeline across the U.S.-Canadian border to bring oil to American refineries.

This issue bears on America's economic concerns in two ways. First, and most directly, Canadian oil can help the United States meet its energy needs cheaply and securely in the coming years. When Harper met with Obama, he made this case plainly, saying: "I think it is clear to anyone who understands this issue that the need of the United States for fossil fuels far in excess of its ability to produce such energy will be the reality for some time to come." Harper added: "[T]he choice...is whether to increase its capacity to accept such energy from the most secure, most stable, and friendliest location it can possibly get that energy, which is Canada, or from other places that are not as secure, stable, or friendly to the interests and values of the United States."

In 2010, 21.5% of America's oil imports came from Canada, compared to 10.9% from Mexico, 9.3% from Saudi Arabia, 8.7% from Nigeria, 8.4% from Venezuela, and 5.2% from Russia. Canada's share of imports continues to rise as oil production in the oil sands grows. The value of a reliable supply of energy from a politically stable, democratic, hospitable, and nearby country should be self-evident. Even so, environmental groups are bent on blocking a new pipeline from Canada to the Gulf Coast — and the Obama administration has dawdled in giving its approval.

But the story of Canada's oil exploration also offers a lesson to America's policymakers about the importance of developing our own domestic energy supplies as part of a broader strategy of economic resurgence. The Obama administration has restricted oil drilling in so many areas — the Outer Continental Shelf, offshore northern Alaska, the Alaska National Wildlife Refuge, much of the Gulf of Mexico, oil shale in the Rocky Mountains — that Canada's oil sands would meet an urgent need. Far better, however, would be to reduce that need by tapping our own resources. Policymakers must rethink their approach to those domestic sources if we are to have any hope of achieving the economic growth required to solve our fiscal problems.

LESSONS OF SUCCESS

What general lessons, then, might America learn from the remarkable success story of our neighbor to the north? Faced with immense fiscal challenges much like those we now confront, how did Canada get things right? Nine lessons, above all, have great bearing on our current troubles.

First, even horrendous fiscal problems can be solved. "The main lesson is it can be done," said David Frum, the Canadian writer who lives in Washington and hosts the web site FrumForum.com. The Canadian formula is no secret: spending cuts, less borrowing, smaller government, decentralized political power, entitlement reform. America's problems cannot be minimized, as Paul Martin explained in an interview, but "the capacity of the U.S. is so great, you'll be able to handle this." Jim Dinning, treasurer of Alberta during the Canadian turnaround, thinks so too — but only if America's leaders are "ready to withstand attacks and abuse and not blink."

Second, national consensus is vital. "I went across the country for 15 months," Martin said, "talking to Canadians about the tradeoffs that had to be made. We built a very strong consensus that we had to act." To be sure, this was easier in Canada (population 34 million) than it would be in the United States (311 million). Martin also took advantage of a dramatic shift in the public's mood. In 1984, fewer than 2% of Canadians considered the deficit and the national debt to be the country's foremost economic problems. By 1990, 80% were "very" or "somewhat" concerned about the deficit. In 1993, 70% favored spending cuts to reduce the deficit over increased spending to stimulate the economy. In America, given the economic crisis and recession of the past few years — as well as the magnitude of our coming fiscal challenges — we may be living through a similar shift in public priorities and desires. But that remains to be seen, and it will take courageous politicians to find out.

Third, spending cuts that take effect quickly are crucial. "Speed is important," the Institute for Government, a London-based think tank, concluded in its 2009 study of Canada's rebound. "Where a high level of societal consensus has been achieved, it is preferable to move expeditiously. It creates hope at the end of the tunnel." In the past, though, Canadian governments had taken what Martin called the "hockey stick" approach, making minimal cuts in the early years and setting the truly steep cuts to come later (imagine the shape of a hockey stick). But the late-arriving cuts rarely materialized. Politicians naturally lose their nerve over time (especially when several election cycles intervene, so that those leaders who actually have to make the cuts are not the same people who enacted them). Setting short-term targets and meeting them is therefore essential. "You can't ask people to endure a hardship, which spending cuts are, if you don't achieve your targets," Martin said. "You need to achieve it in the short run." Canada's liberal leaders did just that.

Fourth, across-the-board spending cuts and budget gimmicks don't work. When Progressive Conservative Brian Mulroney was prime minister from 1984 to 1993, he tried them all: freezes, blanket cuts, and efficiency schemes to "[do] more with less." But he never got control of the deficit, especially because of the massive debt he inherited. "There is no real substitute for making choices about the relative importance of government programmes to eliminate a large deficit," the Institute for Government said. This means specific cuts in specific programs, based on clear-eyed assessments of whether those programs are essential.

Fifth, Keynesianism is not the solution; it is the problem. Keynesianism holds that spending and deficits promote economic growth, while cuts in spending curtail growth. In Canada, the theory was put into practice for decades by Pierre Trudeau — and it failed. During Trudeau's premiership, from 1968 to 1984, spending, borrowing, and debt soared; the economy gradually slipped into the danger zone. Ultimately, Trudeau's policies led to the fiscal crisis of the early 1990s. "The Keynesian argument that big cuts in government spending will slow an economy receives no support from Canada's experience," Henderson wrote in his paper. According to the Keynesian model, "the Canadian economy would have slowed somewhat. It didn't."

Sixth, bigger and more centralized government is not inescapable. "What we learned in Canada was that actually the growth of the state, which seemed so inevitable, is not inevitable and unstoppable," said Brian Lee Crowley, who is also managing director of the Macdonald-Laurier Institute for Public Policy (a conservative think tank in Ottawa). "When faced with real costs — slow growth, high unemployment, increased welfare spending, rising public debt — we said, thanks, but no thanks, we don't want that." Canadians used the debt crisis to diminish the size of their government, with favorable results.

Seventh, don't expect budget surpluses in good economic times to offset deficits in bad years. The theory that, over time, one balances out the other is a fallacy. Without strict controls, politicians will spend, not save, in good times. Canadians discovered this in the decades prior to 1995. "Whatever the economic rationale for that approach, it didn't work in the real world of politicians," Martin wrote in his memoir, Hell or High Water. "Once you break the spell — once governments find that they can get away with borrowing instead of taxing to pay the bills — it is almost impossibly tempting for politicians to do it again and again until the debt is out of control." On this point, Martin is the expert.

Eighth, political leaders can openly defy the environmental movement without suffering political damage. Canadians recognize the critical importance of oil exports to their economy, and both liberal and conservative parties have backed further exploration, with positive results for the economy.

Finally, the most important — but also the most problematic — lesson for the United States is that liberals have to lead the reform effort. If conservatives alone propose to cut spending and downsize government, they are probably doomed to failure because of fierce liberal opposition. But when liberals provide the leadership, most of their followers fall in line and are joined by conservatives. This is exactly what occurred in Canada. Chrétien and Martin, leaders of the Liberal Party, were not expected to advocate a daring shift to the right — or, as they would say, to the center. They were aided by growing popular support for spending restraint, but their leadership was indispensible. They understood that addressing the country's fiscal problems was essential to saving and strengthening the social safety net, and that it therefore had to be a liberal priority.

American liberals have yet to grasp this reality — and their failure has made all the difference. Almost all of the other lessons to be drawn from the Canadian experience could be put into effect here if some prominent Democrats — especially, of course, the sitting Democratic president — supported an effort to do so. Without such leadership on the left, we stand almost no chance of averting disaster.

LOOKING NORTH

The Canadian comeback has sparked a surge of intellectual nationalism among Canadian conservatives. Their decades-long deference to American conservatives has ended as a consequence of Canada's sprint past the U.S. in adopting conservative ideas.

"Under Reagan, conservatives had made big strides," said Crowley. "We watched with great respect and admiration at what conservatives were able to achieve....The intellectual leadership has shifted. We are no longer looking to America to see [in] what direction conservatism is heading. Canada can hold its head up."

American conservatives will hardly notice the rebuff. Like most Americans, they are oblivious to the Canadian success story. Congressman Brady, to his credit, is not. He ordered his Joint Economic Committee staff to examine what makes economies grow, and Canada's experience stood out. "Americans like to believe our economy is unique," Brady said. But the American economy is only marginally different from Canada's.

The substantive economic lessons of the Canadian turnaround are ones American conservatives already know. That swift spending cuts should be preferred over budget gimmicks, and that smaller government and lower taxes should be preferred over Keynesianism, would hardly come as a shock. But the political lessons of the Canadian experience — the need for some consensus, and for some liberal leadership — are not necessarily the accepted wisdom on the American right.

For the left, of course, the entire story should be powerfully instructive. A Democratic leader who pursued the kinds of reforms that Jean Chrétien and Paul Martin undertook could be enormously successful in building bridges across our political divides, as well as in helping the country avert fiscal disaster. Such a leader would be, among other things, a savior of the social safety net. Unfortunately, today's Democratic Party seems very far from producing a leader inclined to follow the Canadian example.